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By Ashish Shah

Chasing returns into-and out of-specific credit sectors happens so often in bond markets that it hardly rates a raised eyebrow. But running with the herd can be risky, which is probably why Federal Reserve officials reportedly have discussed slapping exit fees on bond funds to avoid a disorderly rush to the exit.

We think it's better to step away from the crowd and focus on opportunities across sectors. That can help investors avoid overheated sectors, find bargains and reduce the risk of getting trapped when everyone else heads for the door.

Based on market flows, attitudes toward particular credit assets lately seem a lot like a teenage crush: completely smitten one day and old news the next. Emerging-market mutual funds are a good example. They hauled in $39 billion in flows during 2012, according to EPFR Global, and then lost nearly all of it over the next 15 months. In recent weeks, EMs have come back into favor.

Shifts in sentiment like these can happen faster than many investors are able to react. This is especially true for those who segregate their credit allocations into single-sector funds: high yield, emerging markets and so on. Investors with a longer-term perspective may want to think about holistic multi-sector strategies that allocate to high-income asset classes based on where their managers see specific opportunities. This would make it possible to capitalize quickly on undervalued bonds no matter which sector they're in- opportunities the crowd may miss.

A Contrarian Approach in Credit
Put another way, if the majority of investors are driven by broad momentum swings, a more selective minority can find untapped potential by employing a more contrarian approach.

Consider municipal bonds, which have followed a similar script lately. Municipals are popular because of their tax-exempt income status. But that didn't stop investors from yanking $53 billion out of muni bond funds last year, according to Lipper, causing the sector to post its first negative annual return since the global financial crisis.

What drove the exodus? Fear of rising interest rates, as well as worries about Detroit's record bankruptcy filing and Puerto Rico's solvency. As it turned out, rates haven't climbed as fast as many feared. What's more, many municipal credits that were in sound financial shape were punished for the problems in Puerto Rico and Detroit. A contrarian mindset, some fortitude and disciplined credit analysis would have seen a lot of value in the muni world.

Investors who took this approach have been rewarded this year: investors have poured money back into municipal bonds as they realized the overreaction. So far this year, munis have posted a total return of 5.5% compared with 5.1% for corporate high-yield bonds and 2.2% for U.S. Treasuries, according to Barclays. And that's before adjusting for taxes.

As retail participation in credit sectors rises, similar opportunities are likely to show up in other asset classes. According to JPMorgan, mutual funds held more than 24% of outstanding U.S. high-yield bonds last year, nearly doubled from a 13.5% share in 2001. (Display). Retail funds owned 20% of outstanding leveraged bank loans last year, nearly four times what they owned in 2004. However, the tide may be turning in that particular case: loans have suffered eight straight weeks of outflows.

Avoiding the Rush to the Exit
Investing against the grain, in our view, requires a flexible approach to asset allocation. As we've seen, investors who slice up their credit allocation into silo-like single-sector funds may not be able to move quickly enough to identify and capture relative-value opportunities.

And when sentiment sours, some investors will find it hard to beat the crowd to the door. That's because new regulations are prompting Wall Street dealers to shrink their bond trading desks and pare down their inventories in many credit assets, just as retail demand for them soars.

So, when everyone wants to sell, there will be fewer willing buyers on the other side of the trade. According to Federal Reserve data, banks' corporate bond holdings have declined by roughly 75% since peaking in 2007 at about $235 billion. This has happened even as the issuance of corporate bonds has risen: $1.4 trillion last year, nearly double its 2008 level, according to the Securities Industry and Financial Markets Association.

These liquidity dynamics may have helped magnify last year's sector-specific sell-offs and are likely driving policymakers' discussions about exit fees. And if interest rates rise as expected in the year to come, markets may get more volatile still. We think investors who don't have all their eggs in the same credit basket will be best positioned in such a scenario.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Ashish Shah is Director of Global Credit at AllianceBernstein (NYSE:AB)

Source: Multisector Plan Can Help Avoid The Crowd In Credit